International Banking and Trade Finance

International Banking and Trade Finance Chpt 11

Managing Transaction Exposure Chapter 11

Overview • Identify techniques for hedging transaction exposure • Describe how each technique hedges an MNC’s payables and receivables • Compare the different hedging techniques • Observe other methods that reduce exchange rate risk

Exchange Rate Exposure There are 3 forms by which a MNC is exposed to exchange rate fluctuations • 1. Transaction exposure • 2. Economic Exposure • 3. Translation Exposure

Transaction Exposure Exposure exists when future cash transactions are affected by exchange rate fluctuations • Affects future cash flows • e.g., MNC from US has payables denominated in German marks • 1. identify degree of exposure • 2. decide whether to hedge and if so, then what percent of payables to hedge • 3. select the hedging technique

Before Hedging • Before making any decisions about hedging • you should identify the net transaction exposure on a currency-by-currency basis • Net means all inflows and outflows

Before Hedging • If it turns out that the inflows and outflows, across all the subsidiaries offset each other, then you do not need to hedge !!! • Problem is, individual managers do not like to be exposed because they think it looks bad on their record • So they may hedge Page 335

Before Hedging • If the individual managers hedge, they might erode some of the offset advantages that the whole firm has • It must be kept in mind that the goal of the MNC is to be profitable as a whole - not just each subsidiary • remember when hedging there are transaction costs - its not free Page 335

Transaction Exposure Identifying Net Transaction Exposure • Conduct analysis by currency • calculate the “net” exposure for each currency • make hedging decisions on MNC-wide basis • consolidates all subsidiaries

Transaction Exposure • Hedging within MNC and agency theory • MNC should hedge at the corporate level • subsidiary managers may try to protect their own cash flows • redundant hedging may occur within MNC MNC X:

Transaction Exposure • Corporate level hedging practices may: • 1. create unhedged positions of subsidiary • 2. may increase riskiness of subsidiary’s cash flow • Subsidiary hedging without MNC approval: • may leave MNC exposed

Text’s example of Eastman Kodak Company’s • Irrelevant to us in Canada • we just don’t have that many companies who are so large and have manufacturing and business in so many places that such questions of hedging would be relevant Example of Kodak’s centralized currency management approach

Is Hedging Worthwhile ? • “… on the average it will not reduce the MNCs costs … it could be argued that hedging is not worthwhile…”textpage 336

Canadian companies that might use hedging • Magna • BCE / Nortel • Noranda • Air Canada • Celestica • Xerox

Canadian companies that use hedging • Bombardier • Alcan • Canadian Airlines • McCains

Top companies in Canada that might need to do centralized foreign currency management • … from the class

Transaction ExposureApproaches to Hedging • 1) Hedge only when currency expected to move in direction that makes hedging feasible eg. approach of Black & Decker • if MNC expects the DM to depreciate in value • hedge only inflow exposure (receivables) • if MNC expects the DM to appreciate in value • hedge only outflow exposure (payables) Page 336

Transaction Exposure Approaches to Hedging • 2) Hedge 100 percent of net exposures in foreign currency (Seagram Company) • eliminates uncertainty when valuing expected cash flows • - they don’t do it to make any money, but rather to prevent losing a lot of money, which then helps a lot with planning 100% 100%

“Most MNCs do not perceive their foreign exchange management as a profit center” • that is they do not do hedging to make money -they do it to Page 337 1. Measure exposure in order to assess risk 2. Determine whether the exposure should be hedged 3. Determine HOW the exposure should be hedged

Adjusting the Invoice Policy to Manage Exposure • Sometimes a large company will have to pay for things in “x” from “X” country • It might also sell stuff to “X” country denominated in dollars • One of the things you can do is denominate it in “x” so you balance your exposure • textbook example uses paying in Swiss francs Page 337

Transaction Exposure Hedging Techniques • 1) Futures hedge • 2) Forward hedge • 3) Money market hedge • 4) Currency option hedge

1. Futures Hedge (Currency Futures) Page 338 • Characteristics of contract • buyer of futures contracts • depends if your purpose is payables or receivables • entitled to receive a specified amount in a specified currency for a stated price on a specified date • expects the currency to appreciate in value • if it appreciates, then they will have saved money because in the future, they will not have had to pay at the higher price • sometimes they can backfire

2. Forward Hedge (Forward Contract) Page 339 • Used heavily by large corporations • usually because they have to pay for a large amount of material, supplies or component parts • “… contract specifies the exchange rate at which currencies will be exchanges” • if you don’t know the amount, then you have to lock in the rate • if you know the amount, then you could do a currency futures hedge

2. Forward Hedge • Hedging vs not hedging on payables • MNC compares possible outcomes • hedging produces known results • not hedging permits range of possibilities to exist

2. Forward Hedge • Hedging vs not hedging on receivables • MNC compares possible outcomes • hedging produces known results • not hedging permits range of possibilities to exist

3. Money Market Hedge Page 344 • Hedge on payables • basically, if you have the money available, you can but it in the bank, in the denomination of the currency you will need, and the small amount of interest you will earn might cover the possible drop if you did not take this action

3. Money Market Hedge Page 344 • Hedge on payables • If you take this action, it requires you do 2 things • 1. Borrow funds in the particular currency • 2. Make a short term investment in that currency

3. Money Market Hedge on Receivables Page 345 • Hedging on receivables • If you expect some large amount of money coming in (say, $2M Pounds) • Maybe you expect the Pound to drop in the next few weeks so that incoming money will be less in value • What you can do is borrow the 2 million pounds now

3. Money Market Hedge on Receivables Page 345 • Hedging on receivables, continued,,, • Now, for a short period of time you will have to pay interest in the 2 million pounds, but when you payment comes in from the person you are doing business with, you can take that 2 million pounds, and use it to pay back the other 2 million pounds you borrowed

3. Money Market Hedge on Receivables Page 345 • Hedging on receivables, continued,,, • The reason you would want to do this is just in case Pounds dropped very low, the incoming Pounds may not mean much in dollars, but they would still be OK to pay off a short term loan denominated in Pounds !

4. Currency Option Hedge • Unhedged strategies • may outperform hedging strategies • when a payables currency depreciates • when a receivables currency appreciates

4. Currency Option Hedge Page 346 • Sometimes using a Forward Hedge (Forward Contract) and a Currency Hedge (Currency Futures Contract) can backfire, • therefore, people use currency options - only problem is you have to pay a premium for them, which sometimes could negate any small advantages

4. Currency Option Hedge • Hedging payables with call option (buying) • provides right to buy a specified amount of a currency at a specific price with a specified time period • does not obligate the owner to buy the currency Page 346

4. Currency Option Hedge • Hedging receivables with currency put options • provides right to sell a specified amount of a currency at a specific price within a specified time period • does not obligate the owner to sell the currency Page 347

4. Currency Option Hedge • Hedging receivables with currency put options • if the existing spot rate of the foreign currency is above the exercise (strike) price when the firm receives the foreign currency, the firm can sell the currency received at the spot rate and let the put option expire Page 347

Comparison of Hedging Techniques Page 348

Comparison of Hedging Techniques In the textbook, they spend some pages explaining the different hedge techniques on pages 349, 350 and 351, only to conclude on page 352 that “… Fresno Corporation is likely to perform best if it remains unhedged…” “…While the hedging techniques described in this chapter can be useful, they have limited effectiveness for the long term” Page 352 Page 355

Limitation of RepeatedShort-term Hedging • Long-term hedging • may be more effective than a series of short-term hedges • when a currency enters a long cycle of strength or weakness • e.g., Deutsche mark strengthened against most currencies in the early 1990s • long term hedges would have been more effective

Long-term Transaction Exposure • Hedging methods • long-term forward contract • currency swap • parallel loan Reducing Uncertainty

Long-term Transaction Exposure: Hedging • Long-term forward contract • time horizon up to five years • long-term payables (outflow) exposure • long-term receivables (inflow) exposure • commonly used for major currencies • MNCs that benefit most from this hedging: • have established fixed-price contracts Page 357

Long-term Transaction Exposure: Hedging Page 357 Currency swap • works well for two companies that have long term expectations of being exposed to a currency, so they get their bankers to “swap” the exposure for a better currency, or their own

Long-term Transaction Exposure: Hedging Page 357 Currency swap • see handout given to class from WWW • http://www.finpipe.com/currswaps.htm • Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets

Long-term Transaction Exposure: Hedging Page 357 Currency swap • from http://www.finpipe.com/currswaps.htm • Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities • Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap

Long-term Transaction Exposure: Hedging Page 357 Currency swap • from http://www.finpipe.com/currswaps.htm • Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currency's notional against the other currency's notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain. This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange. This explains why currency swaps tie up greater credit lines than regular interest rate swaps.

Long-term Transaction Exposure: Hedging • Example of a swap serving two MNCs • MNC A is a French firm • committed to a four year contract in the US • expects to receive $6,000,000 at end of fourth year • MNC B is a US firm with a contract in France • will receive FF35,000,000 in four years • MNCs A and B, with a bank’s help, arrange swap • permits the exchange of $US for FF at an agreed price

Long-term Transaction Exposure: Hedging • Parallel loan • a two-step currency exchange agreement • two MNCs agree to: • 1) exchange FF for $US • 2) re-exchange $US for FF at a specified exchange rate and a specified time • requires two currency swaps • at inception of loan and at the second exchange

Alternative Hedging Techniques • Three common methods • leading and lagging • cross hedging • currency diversification • Reduce exposures formed from poor forecasts • standard hedging works best when MNCs accurately forecast future exchange rates

Alternative Hedging Techniques • Leading and lagging • adjust the timing of payments or receipts • expects currency change to affect receivables or payables • leading, moves up transaction • lagging, postpones transaction

Alternative Hedging Techniques • Cross hedging • reduces transaction exposure in a currency that cannot be hedged directly • hedges with a currency that is highly correlated with the desired currency

International Banking and Trade Finance